Arkansas Administrative Code
Agency 003 - DEPARTMENT OF COMMERCE
Division 02 - Bank Department
Rule 003.02.05-003 - 46-305.1 - Applications / Documents; 47-401.2 - Investment - Consumer Paper; 47-501.1 - Certificates of Reliance

The bank should determine the need for insurance by identifying the specific risk of loss or obligation to be insured against. The existence of a risk of loss or an obligation does not necessarily mean that a national bank can purchase or hold an interest in life insurance. For example, a national bank may not purchase life insurance on a borrower as a mechanism for effecting a recovery on obligations that have been charged-off, or are expected to be charged-off for reasons other than the borrower's death. 3 Also, a national bank should surrender or otherwise dispose of permanent life insurance acquired through debts previously contracted (DPC) within a short time frame, generally 90 days, of obtaining control of the policy. 4

Additionally, the purchase of insurance to indemnify a national bank against a specific risk does not relieve a national bank from other responsibilities related to managing that risk. For example, a national bank may purchase life insurance to indemnify itself from the loss of a "key-person." However, "key-person" life insurance should not be used in place of, nor does it diminish the need for, adequate management or "key-person" succession planning.5

The bank should estimate the size of the obligation or the risk of loss and ensure that the amount of insurance purchased is not excessive in relation to the estimate. For such estimates, national banks may include the cost of insurance and the time value of money in determining the amount of insurance needed. The estimate of the amount of insurance needed should be based on reasonable financial and actuarial assumptions. In situations where a national bank purchases life insurance on a group of employees or a homogenous group of borrowers, it can estimate the size of the obligation or the risk of loss for the group on an aggregate basis and compare that to the aggregate amount of insurance purchased.

Purchasing or holding excessive permanent insurance may be an unsafe and unsound practice if it subjects the bank to unwarranted risks. Bank-owned life insurance subjects the bank to several risks which may be significant. The risks are explained in the "Risks Associated With COLI" section of this bulletin.

The vast majority of COLI purchases are made through vendors, either brokers/consultants or agents. Most corporations have used brokers/consultants. However, some corporations have purchased COLI through agents who work for specific insurance companies. It is also possible to purchase COLI directly from insurance carriers without using a vendor.

The role of the vendor, if any, depends on the type of vendor selected. For example, the vendor may be an agent of a specific insurance company who serves as the bank's primary contact with the insurance company, explains the company's various products, and helps the bank in making product selection. Or, the vendor may be an independent broker who has established working relationships with many insurance companies. In addition to being the bank's primary contact with the insurance company, the broker will work with the bank in selecting a carrier and in designing, negotiating, and administering/servicing the COLI.

The bank does not have to use a vendor. In deciding whether or not to use a vendor or what type of vendor to use, the bank should consider its knowledge of COLI, the amount of resources it can and is willing to spend servicing/administering the COLI, and the benefits a vendor may provide. Depending on the role of the vendor, the vendor's services can be extensive and critical to successful implementation and operation of a COLI plan. If the bank uses a vendor, it should make appropriate inquiries to satisfy itself regarding the vendor's ability to honor its commitments, which may be long term. In assessing the vendor's ability to honor its commitments, the bank should typically review the vendor's services, general reputation, experience, and financial capacity. The nature and thoroughness of the review should be determined by the size and complexity of the potential COLI purchase.

COLI plans are typically of long duration and may represent significant risks for the bank. Therefore, carrier selection is one of the most critical steps in a COLI purchase. The bank should review the product design, pricing, and administrative services of the carrier(s) and compare them with the bank's needs. In addition, the bank should also review the carrier's ratings, general reputation, experience in the market place, and past performance. A broker/consultant, if used, may assist the bank in this regard.

Furthermore, before purchasing life insurance, the bank should perform a credit analysis on the selected carrier(s) in a manner consistent with safe and sound banking practices for commercial lending. A more complete discussion of the credit analysis is included in the "Credit Risk" section of this bulletin.

There are a few basic types of life insurance products in the marketplace. However, these products can be combined and modified in many different ways. The resulting final product can be quite complex. The bank should review the characteristics of the various insurance products available. It should select the product or products with characteristics that match the institution's objectives and needs. To do this, the bank should thoroughly analyze and understand the products being considered.

When purchasing insurance on "key-persons" and individual borrowers, the bank should consider whether the bank's need for the insurance will be eliminated before the insured individual dies. In such cases, term or declining term insurance may be the most appropriate form of life insurance.6

The bank should analyze the benefits of COLI purchases being considered. The analysis should include an assessment of how the purchase will accomplish the objective specified in "I. Determination of the Need for Insurance." It should also include an analysis of the anticipated performance of the insurance. A more complete discussion of this analysis is included in the "Transaction Risk" section of this bulletin.

Split-dollar insurance arrangements7typically provide additional compensation and/or other benefits to the employee. Before a national bank enters into a split-dollar arrangement, it should identify and quantify the compensation objective, and ensure that the arrangement is consistent with the stated objective. Also, the bank should combine the compensation provided by the split-dollar arrangement with all other compensation to ensure that total compensation is not excessive. Excessive compensation is prohibited as an unsafe and unsound practice. Guidelines for determining excessive compensation can be found in Appendix A to 12 CFR Part 30 - Interagency Guidelines Establishing Standards for Safety and Soundness.

Ownership of or beneficial interests in COLI may subject a national bank to several risks. These risks include: transaction, credit, interest rate, liquidity, compliance, and price. A bank's prepurchase analysis should include a thorough evaluation of these risks. An explanation of each risk is included in the "Risks Associated With COLI" section of this bulletin.

Furthermore, the pre-purchase analysis should allow a national bank to determine whether the transaction is consistent with safe and sound banking practices. In making this determination, a national bank should consider, among other things:

*The complexity of the transaction.

*The size of the transaction relative to the bank's capital.

*The diversification of the credit risk.

*The financial capacity of the bank.

*The financial capacity of the insurance carrier(s).

*The bank's ability to identify, measure, monitor, and control the associated risks.

In assessing the size of the transaction, a national bank should consider the CSV relative to its capital levels at the time of purchase. The bank should also consider projected increases in the CSV and projected changes in capital levels for the duration of the contract.

Consistent with prudent risk management practices, a national bank should establish internal quantitative guidelines. These guidelines generally limit the aggregate CSV of policies from any one insurance company and the aggregate CSV of policies from all insurance companies. Among other things, a bank should consider the legal lending limits ( 12 CFR Part 32) and concentration of credit guidelines (OCC Bulletin 95-7, dated February 9, 1995) when establishing the respective limits.

Some COLI purchases involve indemnifying the bank against a specific risk. For example, COLI is sometimes purchased to indemnify the bank against the potential for loss arising from the untimely death of a "key-person." As an alternative to purchasing COLI, a bank may choose to self-insure against this risk. Other COLI purchases are used to recover costs or provide for employee benefits. In these cases, a bank may choose to generate the necessary funds through investments instead of by purchasing insurance. Regardless of the purpose of COLI, a complete pre-purchase analysis will include an analysis of the alternatives.

The primary objective of this bulletin is to provide guidelines that will help national banks make informed decisions consistent with safe and sound banking practices. In doing so, national banks generally should consider the pre-purchase analysis just described. A national bank should maintain documentation adequate to show that the bank made an informed decision. The bank should continue to monitor that decision based on the standards set forth in this bulletin.

RISKS ASSOCIATED WITH COLI

For purposes of the OCC's discussion of risk, examiners assess banking risk relative to its impact on capital and earnings. From a supervisory perspective, risk is the potential that events, expected or unanticipated, may have an adverse impact on the bank's capital or earnings. The OCC has defined nine categories of risk for bank supervision purposes. These risks are: Credit, Interest Rate, Liquidity, Price, Foreign Exchange, Transaction, Compliance, Strategic, and Reputation. These categories are not mutually exclusive; any product or service may expose the bank to multiple risks. For analysis and discussion purposes, however, the OCC identifies and assesses the risks separately.

The applicable risks associated with COLI are: Transaction, Credit, Interest Rate, Liquidity, Compliance, and Price. The definitions of these six risks are summarized below. For complete definitions, see the "Bank Supervision Process" booklet of the Comptroller's Handbook. An analysis of how each of these risks impact the decision to purchase and hold COLI is set forth in the following paragraphs.

Transaction Risk

Transaction risk is the risk to earnings or capital arising from problems with service or product delivery. The degree of transaction risk associated with COLI is a function of a bank not fully understanding or properly implementing a transaction. In addition to following the other guidelines included in this bulletin, national banks should take two additional steps to help reduce transaction risk. Bank management should have a thorough understanding of how the insurance product works and the variables that dictate the product's performance. The variables most likely to affect product performance are the policy's interest crediting rate,8mortality cost,9and other expense charges. Typically, the most significant variable is the interest crediting rate, followed by the mortality cost. Therefore, before purchasing COLI, a national bank should analyze projected policy values (CSV and death benefits) from multiple illustrations provided by the carrier. Banks should consider using different interest crediting rates and mortality costs assumptions for each illustration.

Bank management should also understand and analyze how COLI will affect the bank's financial condition. Given the anticipated performance of the insurance, management should analyze the effect on the bank's earnings, capital, and liquidity. Management should also consider the impact on the bank's earnings and capital should the bank, for any reason, surrender the insurance before maturity at the death of the insured.

Credit Risk

Credit risk is the risk to earnings or capital arising from an obligor's failure to meet the terms of any contract with the bank or otherwise fail to perform as agreed. All life insurance policyholders are exposed to credit risk. The credit quality of the insurance company and duration of the contract are key variables. With term insurance, credit risk arises from the insurance carrier's contractual obligation to pay death benefits upon the death of the insured. Credit risk is primarily a function of the insurance carrier's ability (financial condition) and willingness to pay death benefits as promised. Credit risk may be reduced by the support provided by state insurance guaranty associations or funds. A bank's credit exposure through the ownership of term life insurance is not reflected on the bank's balance sheet.

With permanent insurance, credit risk arises from the insurance carrier's obligation to pay death benefits upon death of the insured and from its obligation to return the CSV to the policyholder upon request. The risk is similar to that with term insurance, but there are a few differences. With most permanent insurance COLI plans, the expected time frame for collection of death proceeds is extremely long term. Additionally, the CSV is an unsecured, long-term, and nonamortizing obligation of the insurance carrier. The risk inherent in the insurance company's failure to return the CSV value is, reflected on the bank's balance sheet.

Before purchasing life insurance, bank management should evaluate the financial condition of the insurance company and continue to monitor its condition on an ongoing basis. In addition to reviewing the insurance carrier's ratings, the bank should conduct an independent financial analysis consistent with safe and sound banking practices for commercial lending. As with lending, the depth and frequency of the analysis should be a function of the relative size and complexity of the transaction.

Interest Rate Risk

Interest rate risk is the risk to earnings or capital arising from movements in interest rates. General account 10 products expose the policyholder to interest rate risk. The interest rate risk of these products is primarily a function of the policy's interest crediting rate. Interest crediting rates are established by the insurance carrier. Over the long term, interest crediting rates are primarily a function of the carrier's investment portfolio performance. The policy's CSV is negatively affected (grows at a slower rate) by a declining interest crediting rate. Since a bank's investment in permanent insurance is recorded at the policy's CSV, the bank's earnings decline as the policy's interest crediting rate declines.

Due to the interest rate risk inherent in this product, it is particularly important that management fully understand the risk before purchasing the policy. Before purchasing permanent insurance, bank management should:

*Review the policy's past performance over various business cycles.

*Analyze projected policy values (CSV and death benefits).

*Consider having the carrier use a different interest crediting rate for each set of policy projections.

Variable or separate account 11 products may also expose the bank to interest rate risk depending on the types of assets held in the separate account. For example, if the separate account assets consist solely of Treasury securities, the bank is exposed to interest rate risk in the same way as holding Treasury securities directly in its investment portfolio. However, because the bank does not control the separate account assets, it is more difficult for the bank to control this risk. Therefore, before purchasing a separate account product, bank management should thoroughly review and understand the instruments governing the investment policy and management of the separate account. Management should understand the risk inherent within the separate account and ensure that the risk is appropriate for the bank. Also, the bank should establish monitoring and reporting systems that will enable the bank to monitor and respond to price fluctuations.

Liquidity Risk

Liquidity risk is the risk to earnings or capital arising from a bank's inability to meet its obligations when they come due, without incurring unacceptable losses. Usually, life insurance policies are not marketable and are illiquid. A secondary market for life insurance does not exist. Although the CSV of policies can be accessed quickly, it typically involves substantial loss. To access the CSV, the bank must withdraw from or borrow against the policy. This may subject the bank to surrender charges, taxes on the gain, and a tax penalty. In addition, the policyholder generally does not receive any cash flow until the death benefit is paid. The lack of liquidity in the product is more significant given that banks normally purchase life insurance policies through a conversion of a liquid asset (cash or marketable securities).

Before purchasing permanent insurance, management should recognize the illiquid nature of the product and ensure the bank has the long-term financial flexibility to hold this asset in accordance with its expected use. The inability of a bank to hold the life insurance until maturity (collection of death benefits) may compromise the success of the COLI plan.

Compliance Risk

Compliance risk is the risk to earnings or capital arising from violations of, or non-conformance with, laws, rules, regulations, prescribed practices, or ethical standards. Failure to comply with applicable laws, rules, regulations, and prescribed practices (including this bulletin) could compromise the success of a COLI program and result in significant losses for the bank as a result of fines, penalties, or loss of tax benefits. Because tax benefits are critical to the success of most COLI plans, management of a national bank should exercise caution to ensure that its plans comply with all applicable tax laws. In addition, bank management should ensure compliance with other applicable legal and regulatory standards. Other common legal and regulatory considerations include compliance with state insurable interest laws, the Employee Retirement Income Security Act of 1974 (ERISA), sections 23A and 23B of the Federal Reserve Act, 12 CFR Part 215 (Regulation O), and Appendix A to 12 CFR Part 30--Interagency Guidelines Establishing Standards for Safety and Soundness. Due to the significance of the compliance risk, a national bank may want to seek the advice of qualified counsel.

Price Risk

Price risk is the risk to earnings or capital arising from changes in the value of portfolios of financial instruments. Typically, the policyholder of separate account products assumes all price risk associated with the investments within the separate account. Usually, neither the CSV nor the interest crediting rate on separate account products is guaranteed by the carrier. The amount of price risk is dependent upon the type of assets held within the separate account.

Because the bank does not control the separate account assets, it is more difficult for the bank to control the price risk. Therefore, before purchasing a separate account life insurance product, bank management should thoroughly review and understand the instruments governing the investment policy and management of the separate account. Management should understand the risk inherent in the separate account and ensure that the risk is appropriate for the bank. Also, bank management should establish monitoring and reporting systems that will enable them to monitor and respond to price fluctuations.

Banks may purchase separate account insurance products that hold equity securities for the purpose of hedging their obligations under employee compensation and benefit plans. 12 This lessens the effect of price risk on the bank's financial statements because changes in the amount of the bank's liability will be hedged by changes in the value of the separate account assets. An example of such a relationship would be where the amount of the bank's deferred compensation obligation is measured by the value of a stock market index, and the separate account contains a stock mutual fund that mirrors the performance of that index. If the insurance cannot be characterized as an effective hedging transaction, the presence of equity securities in a separate account is impermissible.

In addition to the general considerations discussed above, which are applicable to any separate account product, further analysis should be performed when purchasing a separate account product involving equity securities. At a minimum, national banks should:

ACCOUNTING CONSIDERATIONS

National banks should follow generally accepted accounting principles (GAAP) for financial reporting and Call Report purposes. Financial Accounting Standards Board (FASB) Technical Bulletin 85-4, "Accounting for Financial Purchases of Life Insurance" (TB 85-4) discusses how to account for investments in life insurance. The guidance set forth in TB 85-4 is generally appropriate for all forms of COLI.

Under TB 85-4, a national bank should record its interest in the policy's CSV as an "other asset." The increase in the CSV over time would be recorded as "other noninterest income." In accordance with Call Report requirements, the bank should update its interest in the CSV at least quarterly.

APPLICATION OF THE GUIDELINES

The guidelines in this bulletin are applicable to all purchases of life insurance entered into after the date of this bulletin. Purchases of life insurance policies entered into before the date of this bulletin will be evaluated in the following manner.

Policies purchased after issuance of former Banking Circular (BC)-249, Bank Purchases of Life Insurance

Policies purchased after February 4, 1991, should comply with either the guidelines contained in former BC-249 or with the guidelines in this bulletin.

Policies Purchased before the issuance of former BC-249, Bank Purchases of Life Insurance

Policies purchased before February 4, 1991, are provided a "safe harbor" if the following three conditions are met:

*The policies are convenient or useful in connection with the conduct of the bank's business.

*The policies do not threaten the safety and soundness of the, institution.

*The policies do not represent insider abuse or violate other laws, rules, or regulations.

If these conditions are met, no further action by the bank is needed. However, the OCC may require corrective action at any time during the bank's ownership or while it has a beneficial interest in a policy, if any of the three conditions are not met. Such determinations will be made on a case by case basis.

ORIGINATING OFFICE

For further information about this bulletin, contact the Office of the Deputy Comptroller for Credit Risk at (202) 874-5170.

APPENDIX

COMMON TYPES OF LIFE INSURANCE POLICIES

Life insurance can be categorized into two broad types, temporary insurance and permanent insurance. There are numerous variations of these products. However, basic life insurance provisions generally fall within one or a combination of the following categories.

Temporary Insurance

Temporary insurance consists of the various forms of term insurance. Term insurance provides life insurance protection for a specified time period. Death benefits are payable only if the insured dies during the specified period. If a loss does not occur during the specified term, the policy lapses and provides no further protection. All premiums are retained by the insurance company. Typically, term insurance premiums do not have a "savings component"; thus, term insurance does not usually create cash value.

Permanent Insurance

Permanent insurance is intended to provide life insurance protection for the entire life of the insured. Permanent insurance also differs from term insurance in that its premium structure includes a "savings component." Permanent insurance policy premiums have two components, the insurance cost (mortality cost, 1 administrative fees, sales loads, etc.) and the "savings component." The "savings component" typically is referred to as cash value. The policyholder may use the cash value to make the minimum premium payments necessary to maintain the death benefit protection, may access the cash value by taking out loans or making partial surrenders, or use any combination of these techniques. If permanent insurance is surrendered before death, a surrender charge may be assessed against the cash value. Generally, surrender charges are assessed if the policy is surrendered within the first 10 or 15 years. The amount of money a policyholder will receive upon surrendering a policy is referred to as the cash surrender value (CSV).

There are a variety of types of permanent insurance. Some of these include:

*Whole Life--A traditional form of permanent insurance designed so that fixed premiums are paid for the entire life of the insured. However, premiums may be paid from the CSV. Death benefit protection is provided for the life of the insured, assuming all premiums are paid.

*Universal Life--A form of permanent insurance designed to provide flexibility in premium payments and death benefit protection. The policyholder can pay maximum premiums and maintain a very high cash value. Alternatively, the policyholder can make minimal payments in an amount just large enough to cover mortality and other expense charges.

*General Account--form of whole or universal life insurance where the policyholder's cash value is supported by the general assets of the insurance company.

*Variable or Separate Account--form of whole life or universal life where the policyholder's cash value is supported by assets segregated from the general asset structure of the carrier. Theoretically, the cash value of a separate account insurance policy can go down to zero which would result in termination of the policy. The policyholder assumes all investment and price risk. The separate account is used solely for payment of policyholder benefits.

LIFE INSURANCE AS A FINANCING OR COST RECOVERY VEHICLE FOR BENEFITS PLANS

National banks may, as other corporations frequently do, use corporate-owned life insurance (COLI) as a financing or cost recovery vehicle for pre- and post-retirement employee benefits. In these arrangements, banks and other corporations insure the lives of certain employees to reimburse the corporation for the cost of employee benefits. The group of insured employees is often different from the group of employees who receive benefits. The corporation's obligation to provide employee benefits is separate and distinct from the purchase of the life insurance. The life insurance purchased by the corporation remains a corporate asset even after the employer/employee relationship is terminated. The employees, whether insured or not, have no interest in the insurance (other than their general claim against corporate assets arising from the corporation's obligation to provide the stated benefits). Permanent insurance is used for this purpose.

There are two common methods of financing or effecting cost recovery of employee benefits. The first is the cost recovery method. Under this method, the corporation sustains the cost of providing the employee benefits and the cost of purchasing the life insurance. The corporation holds the life insurance and collects the death benefit to reimburse the corporation for the cost of the benefits and the insurance.

The cost recovery method usually involves present value analysis. The corporation typically projects the dollar amounts of the expected benefits owed to employees and determines the present value of the benefits. Then, the corporation purchases a sufficient amount of life insurance on the lives of certain employees so that the gain (present value of the life insurance proceeds less the present value of the premium payments) from the insurance proceeds reimburses the corporation for the benefit payments.

The second method of financing employee benefits is known as cost offset. With this method, the corporation projects the annual employee benefit expense associated with the benefit plan. Then, the company purchases life insurance on the lives of certain employees. The amount of insurance purchased is great enough so that the income earned on the CSV offsets the benefit expense. The collection of death benefits may further enhance the company's return.

SPLIT-DOLLAR INSURANCE ARRANGEMENTS

National banks may, as many other corporations do, use split-dollar life insurance arrangements to provide retirement benefits and/or death benefits to certain employees. Under split-dollar arrangements, the employer and the employee share the rights to the policy's CSV and death benefits. The employer and the employee may share premium payments. If the employer pays the entire premium, the employee must recognize the economic value of the insurance as taxable income each year. Typically, split-dollar arrangements are set forth in written contracts that specify the terms and conditions of the agreement between the employer and employee.

Split-dollar arrangements may be structured in a number of ways. However, there are three basic types of split-dollar arrangements.

Endorsement Split-Dollar

In endorsement split-dollar arrangements, the employer owns the policy and controls all rights of ownership. The employer provides the employee an endorsement of the death benefit provided to the employee under the plan agreement. The employee may designate a beneficiary for the designated portion of the death benefit.

Under this arrangement, the employer typically holds the policy until the employee's death. At that time, the employee's beneficiary receives the designated portion of the death benefits, and the employer receives the remainder of the death benefits.

Collateral Assignment Split-Dollar

The employee owns the policy and controls all rights of ownership. Under these arrangements, the employer usually pays the entire premium or a substantial part of the premium. The employee assigns a collateral interest in the policy to the employer that is equal to the employer's interest in the policy. The employer's interest in the policy usually is equal to the premium paid by the employer or the premium plus a return on the premium.

Under this arrangement, the employee upon retirement usually has an option to buy the employer's interest in the policy. The employee usually withdraws money from the cash value or borrows against the cash value to purchase the policy. Sometimes, the employer may give the employee a bonus to purchase the employer's interest in the policy, or the employer may simply give the employee the corporation's interest in the policy as a bonus. This transfer of the employer's interest to the employee is typically referred to as a "roll-out."

If a "roll-out" is not provided or exercised, the employer does not receive its interest in the policy until the employee's death. Upon the employee's death, the employer would receive an amount equal to the premium paid or the premium plus a return on the premium. The employee's beneficiary would receive the remainder of the death benefits.

If the employee dies before reaching retirement age, the insurance policy's death benefit may be divided a number of ways. For example, the employer may receive an amount equal to the premium paid or the premium plus a return on the premium, and the employee's beneficiary would receive the remainder of the death benefit. As an alternative, the employer may retain the policy's entire death benefit.

Reverse Split-Dollar

Reverse split-dollar arrangements are very similar to collateral assignment split-dollar. The employee owns the policy and the employee provides the employer with an endorsement of part of the death benefit. The employer's interest in the policy is usually equal to or closely related to the pure insurance protection and used as "key-person" insurance. The employer's share of the premium is equal to the economic value of the pure insurance protection. The employee's interest in the policy is typically equal to or closely related to the cash value of the policy. The employee pays the remainder of the premium. This type of split-dollar arrangement is not frequently used in banks.

Split-Dollar Insurance Arrangements Used for Estate Planning Purposes or to Fund Buy-Sell Agreements

National banks may use split-dollar insurance arrangements as an estate planning tool for insiders or to fund buy-sell arrangements between the bank and insiders. However, such arrangements should be part of a reasonable compensation program. As stated in part VII of the pre-purchase analysis, national banks should combine the additional compensation provided to the insured by the split-dollar arrangement with all other compensation provided to the insured. Furthermore, national banks should ensure that total compensation provided to the insured is not excessive. Excessive compensation is prohibited as an unsafe and unsound practice. Guidelines for determining excessive compensation can be found in Appendix A to 12 CFR Part 30-Interagency Guidelines Establishing Standards for Safety and Soundness.

Typically, shareholders and other insiders who are not bank employees or directors do not provide goods or services to the bank and do not receive compensation. Therefore, national banks should only participate in such arrangements as a means of providing compensation for goods or services provided by insiders.

"KEY-PERSON" INSURANCE

A national bank may obtain life insurance to protect itself against the loss of "key-persons." As such, a national bank may purchase insurance on the life of an employee whose death would be of such consequence to the bank as to give it an insurable interest in his or her life. Certain directors of the bank may also be "key-persons."

The purpose of "key-person" insurance is to indemnify the bank against a potential loss of net income that may result from the untimely death of the insured employee. The determination of whether an individual is a "key-person" does not turn on that individual's status as an officer, but on the nature of the individual's economic contribution to the bank.

The first step in indemnifying a bank against the loss of a "key-person" is to identify the "key- person." In essence, a "key-person" is anyone whose absence for an extended period of time would result in a significant loss of net income for the bank. The next and possibly most difficult step is estimating the value of the "key-person." The value of the employee is an estimate of the potential loss of net income that the bank may incur from the untimely death of the "key-person." This value should be an estimate of the impact on net income from the loss of revenues, increased expenses, loss of operating efficiency, or other profit reductions that may result from the untimely death of the "key-person." This estimate of loss should represent a significant amount of the bank's profit or profit potential.

Determining the value of a "key-person" is not easy. Also, the most appropriate method for determining the value of a "key-person" is dependent upon the individual circumstances that created the "key-person" status. For these reasons, the OCC has not established a formula nor a specific process for estimating the value a "key-person" brings to a bank. Instead, the OCC affords bank management the opportunity to consider and analyze all relevant factors, and use their judgment to make the decision.

Additionally, "key-person" life insurance should not be used in place of, and does not diminish the need for, adequate management or "key-person" succession planning. Indeed, if a bank has an adequate management or "key-person" succession plan, its reliance on a "key-person" should decline as the person gets closer to retirement. Since a bank's reliance on a "key-person" declines as the individual moves toward retirement, the potential loss of net income which may result from the death of a "key-person" also should diminish.

As previously stated, holding permanent insurance in an amount in excess of the bank's risk of loss may be an unsafe and unsound practice. 2 Once an individual, because of retirement, resignation, discharge, change of responsibilities, or for any other reason, is no longer a "key-person" for the bank, the bank's risk of loss has been eliminated. Therefore, national banks may be required to surrender or otherwise dispose of life insurance held on a former "key-person." For this reason, the economic consequences of terminating the insurance should be considered in selecting the type of insurance and in structuring the policy. Typically, term or declining term insurance may be the most appropriate form of life insurance for "key-person" protection. It also may be appropriate to use permanent insurance that allows the substitution of insureds to provide for this protection.

LIFE INSURANCE ON BORROWERS

State law generally recognizes that a lender has an insurable interest in the life of a borrower to the extent of the borrower's obligation to the lender. In some states, the lender's insurable interest may equal the borrower's obligation plus the cost of insurance and the time value of money. Furthermore, national banks may protect themselves against the risk of loss from the death of a borrower. That protection may be provided through self-insurance in the form of debt cancellation contracts, or by the purchase of life insurance policies on borrowers.

National banks can take two approaches in purchasing life insurance on borrowers. First, a. national bank can purchase life insurance on an individual borrower for the purpose of protecting the bank specifically against loss arising from that borrower's death. Second, a national bank may employ a cost recovery technique similar to that used in conjunction with employee benefit plans. Under this method, the bank insures a group of borrowers in a homogenous pool of loans for the purpose of protecting the bank from loss arising from the death of any borrower in the homogenous pool. Examples of homogenous pools of loans include consumer loans that have distinctly similar characteristics such as automobile loans, credit card loans, and residential real estate mortgages.

Regardless of which approach is used, national banks should adhere to part 11 of the pre-purchase analysis. That is, banks should determine the risk of loss and ensure that the amount of insurance purchased is not excessive in relation to that estimate. When purchasing insurance on individual borrowers, bank management should, given the facts and circumstances known at the time of the insurance purchase, take reasonable efforts to ensure that the expected insurance proceeds match the expected repayment terms of the debt. To accomplish this, management should estimate the risk of loss over the life of the loan and match the anticipated insurance proceeds to the risk of loss. The insurance policy should be structured so that the expected death proceeds never substantially exceed the risk of loss. Generally, the risk of loss will be closely related to the outstanding principal of the debt. To properly structure the insurance policy, consideration should be given to the repayment terms of the debt. For example, for amortizing credit, banks should typically choose declining term insurance where the death proceeds are decreasing in amounts that match the loan amortization.

As previously stated, holding permanent insurance in an amount in excess of the bank's risk of loss may be an unsafe and unsound practice. 3 Once a credit is repaid, otherwise satisfied in full, or charged-off, the bank's risk of loss has been eliminated. Therefore, national banks may be required to surrender or otherwise dispose of life insurance on individual borrowers under these circumstances. For this reason, the economic consequences of terminating the insurance should be considered in selecting the type of insurance and in structuring the policy. Typically, term or declining term insurance is the most appropriate form of life insurance for insuring the lives of individual borrowers.

When purchasing life insurance on borrowers in a homogenous pool of loans, bank management should, given the facts and circumstances known at the time of the insurance purchase, take reasonable efforts to match the insurance proceeds on an aggregate basis to the total outstanding loan balances. If allowed by state law, national banks may match the insurance proceeds to the outstanding loan balances plus the cost of insurance on either a present value or future value basis. This relationship should be maintained throughout the duration of the program. When using this aggregate or group concept, it is acceptable for banks to continue to hold policies on the lives of borrowers that have been charged-off. However, loans in the homogeneous pool cannot include loans that have been charged-off. This will help ensure that national banks using this approach do not hold life insurance once the risk of loss has been eliminated.

The purchase of life insurance on a borrower is not an appropriate mechanism for effecting a recovery on obligations that have been charged-off, or are expected to be charged-off for reasons other than the borrower's demise. In the case of charged-off loans, the purchase of life insurance does not protect the bank from a risk of loss since the loss has already occurred. Since the insurance does not protect the bank from a risk of loss, the bank does not need the insurance. Holding insurance the bank does not need may subject the bank to unwarranted risks, an unsafe and unsound banking practice. In the case of loans the bank expects to charge-off for reasons other than the borrower's demise, the risk of loss is so pronounced that the purchase of life insurance by the bank would be purely speculative and an unsafe and unsound bankin gpractice.

LIFE INSURANCE AS SECURITY FOR LOANS

National banks may take an interest in an existing life insurance policy as security for a loan. National banks also may make loans to individuals to purchase life insurance, taking a security interest in the policy. As with any other type of lending, extensions of credit secured by life insurance should be made on terms that are consistent with safe and sound banking practices. For instance, the borrower should be obligated to repay the loan according to an appropriate amortization schedule.

Generally, a national bank may not rely on its security interest in a life insurance policy to extend credit on terms that excuse the borrower from making interest and principal payments during the life of the borrower with the result that the bank is repaid only when the policy matures at the death of the insured. Lending on such terms is generally speculative and an unsafe and unsound banking practice.

Frequently, banks acquire ownership of life insurance policies through debts previously contracted (DPC). That is, banks invoke their security interest in a policy after a borrower defaults. Life insurance policies do not have a secondary market. National banks should surrender or otherwise dispose of permanent life insurance acquired through DPC within a short time frame, generally 90 days, of obtaining control of the policy. It is possible that a national bank may find a means to dispose of permanent life insurance acquired through DPC which would require a longer holding period. Therefore, a national bank may request an extended holding period from its supervisory office. In order to receive an extension, the bank should have a well-documented plan that is reasonably certain to allow the bank to dispose of the policy through means other than speculating on the death of the insured. Additionally, the extended holding period should be in the best interest of the bank.

National banks may retain temporary insurance until the next renewal date or the next premium date, whichever comes first. National banks may not continue to make premium payments on term insurance acquired through DPC. This activity is speculative and an unsafe and unsound banking practice.

Emory W. Rushton

Senior Deputy Comptroller for Bank Supervision Policy

1 The appendix contains a discussion of each of these four uses of COLI.

2 Permanent insurance and cash surrender value are described in the appendix on page 1.

3 The purchase of life insurance on borrowers whose obligations have been charged-off, or are expected to be charged-off, is further discussed in the appendix on pages 6-7.

4 Life insurance acquired through DPC is further discussed in the appendix on page 7.

5 The relationship between "key-person" insurance and management succession planning is discussed in the appendix on pages 4-5.

6 "Key-person" insurance and life insurance on borrowers are discussed further in the appendix on pages 4-7.

7 Split-dollar insurance arrangements are defined and discussed in the appendix on pages 3-4.

8 The interest crediting rate refers to the gross yield on the investment in the insurance policy, i.e., the rate at which the cash value increases before considering any deductions for mortality cost, load charges, or other costs that are periodically charged against the policy's cash value. Insurance companies frequently disclose a current interest crediting rate and a guaranteed minimum interest crediting rate. The guaranteed rate may be less than the current rate. As a result, the potential exists for future declines in the interest crediting rate.

9 Mortality cost represents the cost imposed on the policyholder by the insurance company to cover the amount of pure insurance protection for which the insurance company is at risk.

10 General account products are defined in the appendix on page 2.

11 Variable or separate account products are defined in the appendix on page 2.

12 An economic hedge exists when changes in the value of the liability or other risk exposure being hedged are offset by counterbalancing changes in the value of the hedging instrument.

1 Mortality cost represents the cost imposed on the policyholder by the insurance company to cover the amount of pure insurance protection for which the insurance company is at risk. With term insurance, the insurance company is generally exposed to risk of loss for the entire face amount of the policy. With permanent insurance, the net amount at risk for the insurance company is the difference between the policy's death benefit and the cash value,

2 See part (II), Quantification of the Amount of Insurance Needed, of the pre-purchase analysis on page 4 of the bulletin.

3 See part (II), Quantification of the Amount of Insurance Needed, of the pre-purchase analysis on page 4 of the bulletin.

SIGNED: FRANK WHITE BANK COMMISSIONER

RESOLUTION OF THE STATE BANKING BOARD

SEPTEMBER 21, 1995

SUBJECT: MERGER OR CONSOLIDATION

The Arkansas State Banking Board, with the concurrence of the Bank Commissioner and according to its authority under A.C.A. §. 23-32-701(16), hereby adopts the following Resolution:

Arkansas state chartered banks may merge or consolidate, by vote of two thirds of each class of its capital stock, with a stock federal or state savings association, in the same manner in which a national bank is authorized, pursuant to Title V of the Federal Deposit Insurance Corporation Improvement Act of 1991 (12 U.S.C. 215c(a)). Merger and/or consolidation provisions of state and federal law and regulations will be applied in consideration of such application.

Signed this 21st day of September 1995.

SIGNED: ROBERT M. HILL CHAIRMAN

APPROVED: BILL J. FORD BANK COMMISSIONER

* This policy or resolution was adopted by the Arkansas State Banking Board prior to the enactment of the Arkansas Banking Code of 1997.

RESOLUTION OF THE STATE BANKING BOARD

AUGUST 8, 1996

SUBJECT: INVESTMENT, LIMITED LIABILITY COMPANIES

The Arkansas State Banking Board, with the concurrence of the Bank Commissioner and according to its authority under A.C.A. §. 23-32-701(16), hereby adopts the following resolution:

Arkansas state chartered banks may invest in a limited liability company (LLC) to the same extent that a nationally chartered bank may do so provided such investment must be made through a subsidiary and will be subject to the restrictions on investments and loans to bank subsidiaries contained in A.C.A. § 23-32-701. The standards a state chartered bank are subject to for investing in a limited liability company are the same investment standards or requirements that must be met by national banks. These standards, as set by the Office of the Comptroller of the Currency, that must be satisfied by the investing bank are: